For Employers, a Hidden Downside to 401(k) Plans

When companies ditch their traditional pension plans in favor of defined-contribution plans such as 401(k)s, investors typically cheer. After all, 401(k) plans shift uncertainty about market ups and downs off of corporate balance sheets and onto employees’ shoulders.

But there may be a significant cost to those decisions down the road in the form of stagnation in the top ranks and an exodus of young stars, according to new research by Haig Nalbantian, a senior partner at human-resources consulting firm Mercer.

In an unpublished analysis, Nalbantian examined the talent flows in two similar client companies – both global, mature, consumer-products firms whose general approach to talent is to promote employees into upper levels rather than hire from outside.

Company A – Mercer declined to identify the clients – jettisoned its pension plan in the late 1990s and instituted a 401(k). Company B maintained its pension plan despite internal and external pressure to abandon it.

There was no obvious workforce impact of either decision until the recession began interfering with typical retirement patterns, Nalbantian says.

As the economy slowed, Company A began to develop choke points in its talent pipeline: a lack of retirements was preventing young go-getters from moving up in the organization. The company’s “velocity,” or the percentage of people getting promoted or making lateral moves, stalled at 11%.

A map of the company’s internal labor market showed that, at the senior professional and senior manager levels, the probability of moving up dropped considerably. Even worse, said Nalbantian, up-and-comers at those levels were among those with the highest probability of quitting.

“They were stalling out in their careers,” he said. “The future of the organization was walking out the door.”

Meanwhile, Company B had no such choke points. Its velocity was about 18% even in a tepid economy. And far fewer of its active employees were eligible for retirement than at Company A, indicating that individuals were retiring as expected. Average retirement age for Company A workers who joined after the 401(k) was established was 64; at Company B, the average was around 60.

Nalbantian and his colleagues at Mercer’s retirement-consulting practice believe the retirement-plan design is the variable distinguishing the dynamics at the two firms.

Pension plans provide inherent incentives for people to retire, unlike 401(k)s, which are based on a balance that rises or falls depending on which way the markets’ wind is blowing. So “companies that got rid of defined-benefit plans were making a decision to eliminate their ability to strongly influence employees’ decisions to stay or leave,” he said.

Those companies were guided by spreadsheets that were tough to argue with, said Nalbantian. “But what they weren’t doing was looking at the likely workforce impact of those decisions,” he said.

The shift to 401(k)s is also considered a sign of a more transactional relationship between employers and employees. Companies offer less security and stability to the workforce and workers in turn offer less loyalty, making them more likely to leave when an opportunity opens up elsewhere.

“Do firms really transfer the risk when they’re giving up their ability to influence retirement dynamics?” he asked. “Each person who stays on creates a cascade of impacts down the row. So you don’t need a lot of delays in retirement to create the phenomenon of choke points.”

What’s the impact for employers? Increased costs because of turnover; stagnation, as people “retire on the job” and simply stop striving for promotions; and lack of innovation, because “you need replenishment to make sure you’re not living in the past,” said Nalbantian.

However, even evidence of these effects isn’t enough to reverse the decline of pension plans. Nalbantian presented his analysis to Company A three years ago and it didn’t reinstate the pension plan. Instead, it found ways to dissolve the choke points by emphasizing mobility for high performers, even when that meant lateral instead of upward moves.

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